Most tactical asset allocation managers are bullish on bonds.
TAA managers - with models sensitive to every conceivable market, investor and economic signal - migrated en masse into heavier bond weightings as domestic interest rates rose during the first six months of the year.
Depending on the nature of their models, a few TAA managers moved into higher cash positions.
Domestic equities were the overwhelming casualty in most portfolios. Many TAA managers are fleeing an overvalued domestic stock market they say is destined to sharply underperform in the face of rising interest rates.
"There is a startling dichotomy now that we haven't seen often on a historical basis," said Rob Arnott, president and chief executive officer of First Quadrant Corp., Pasadena, Calif.
"The U.S. bond market is the third most attractive in the world right now (behind Canada and Sweden) compared to the U.S. stock market at this point, which is the second least attractive (just ahead of Australia). Coupled with the rise in long-term interest rates, this environment leaves us not so much ferociously bearish on stocks, as it does mildly bullish on bonds. The long-term yields look so good right now."
First Quadrant made a big move into bonds in both its U.S. and global three-way tactical asset allocation portfolios. The firm has been overweighting the bonds all year in its domestic portfolios, moving to 85% this month from 55% in January on a composite basis. The bond benchmark is 35%.
For global portfolios, bonds were increased to 60% from 34% in January; the benchmark is 40%. The global strategy diversifies across 18 countries; Mr. Arnott mildly favors the bond markets in Japan, Hong Kong and Singapore. First Quadrant's model also is mildly favorable on North American and European bond markets. First Quadrant manages about $6 billion in active asset allocation of all types for U.S. institutional investors.
"It's hard to justify being out of bonds now, with real yields between 4% and 9%. There are huge real yields out there. There are plenty of attractive bond markets out there. (There's) not a single bond market worldwide that we don't think looks pretty good. The perceived interest rate volatility is basically a myth. After two years of unprecedented low market volatility - 1992 and 1993 - we're back to an environment where volatility is getting back to normal," said Mr. Arnott.
Bonds are used as an opportunistic vehicle in the three-way asset allocation model designed by Forstmann-Leff Associates Inc., New York, with about $3 billion under management for U.S. institutions. The model employs quantitative and qualitative screens and is extremely interest-rate sensitive, said Sarah J. Rife, vice president and director of client liaison. The program's dividend-discount model determined in February that the equity market was extremely overvalued and risky.
Forstmann-Leff has kept a constant 10% cash position over the past seven months, but has gradually reduced its equity position to 65% from 85% in January. Bonds moved to 25% of the portfolio from 5%.
The firm uses the level of investment in retail equity mutual funds as an indicator within the model. "We've noted the very strong correlation between the rise in interest rates and a slackening of inflows to equity mutual funds. Investors' perceptions change and they move into cash. A drop in the yields on T-bills has a huge effect on inflows to equity funds - the lack of demand from mutual funds in equity markets has a devastating effect overall," said Ms. Rife.
"We only go into bonds when our model shows market conditions are optimal and we are getting close to that level. The bond market has been taken down much too far in reaction to the inflation scare, and we really feel that the market will come back and long rates will correct themselves. Bonds are starting to look very attractive relative to what's available in the equity markets.".
Wishing for freedom
Some TAA managers seem to long for a bit more freedom from their disciplined, quantitatively driven models.
"Active management would have been great this year," said index TAA manager Deborah Goodman, vice president and director of quantitative investment strategies at First Interstate Bank of California, Los Angeles. First Interstate manages more than $825 million on behalf of U.S. institutional clients using its three-way strategy, which allocates assets among equity and bond index funds and cash.
"Because we take a long-term view, with a three- to five-year horizon, not six months or a year, we're looking at long-term volatility," said Ms. Goodman. "Our model shows interest rates rising over time, equities dropping, and the returns on cash so low that it's not worth moving into it, even as a defensive strategy.
"Short term, people might think this strategy (of moving into bonds) is crazy in what seems like a volatile bond market, but it will look great long term."
First Interstate gradually has increased its bond weighting to 57% this month from 47% in March and 37% in January, and hasn't taken any positions in cash this year.
INVESCO Management & Research, Boston, with $190 million of institutional assets managed in a five-way "multiple asset strategy," has moved money to fixed income from real estate investment trusts and small-cap equities during the first half of the year. Fixed income is now at 23.5%, up from 15.5% in January.
Most of INVESCO's clients use a target of 20% - and a range of zero to 40% - in each of five asset classes: large-cap, small-cap and international equity; fixed income; and real estate (through REITs).
"Traditionally, as interest rates rise, fixed income becomes a more attractive prospect," said Robert Slotpole, vice president. "But our model is sensitive to interest rates, which points to a serial correlation between a rise in interest rates and a worsening of the performance of small-cap stocks. Small caps took a big hit in the first half of 1994 and their tendency is to continue to drop as interest rates rise. Real estate is also sensitive to interest rate changes, hence our slight reduction in weighting in that asset class."
Others bullish on bonds are: Wells Fargo Nikko Investment Advisors, with $15 billion under management in TAA accounts; Mellon Capital Management, with $11 billion under TAA management; PanAgora Asset Management Inc., with $7 billion in asset allocation strategies; Windham Capital Management, with $500 million under TAA management; and Stuyvesant Capital Management Corp., with $70 million under management in balanced strategies.
Some driven to cash
Not every TAA manager is using the rise in interest rates as an opportunity to buy bonds. Economic signals have driven some TAA managers into cash as a safe haven.
RTE Asset Management, Wyncote, Pa., manages $1.3 billion for institutional clients in what Denis Hauser, director of research, described as a moderate, balanced TAA strategy. In January, most client accounts had a maximum exposure to bonds of between 70% and 100%, with no equity exposure. By July, most client accounts were almost entirely invested in cash.
"Equity and bond valuations are just way out of line now. Equities are especially overvalued. The interest rate environment is negative for stocks, and we don't see anything coming to change that. Just last week, more concern was expressed about inflation; it's not really being moderated. Our model is pretty negative on both stocks and bonds. We need to see a decline in interest rates or earnings improvement before our model will kick us back into these asset classes," said Mr. Hauser.
Avatar Associates Investment Counsel Inc., New York, also has moved into a defensive position, using cash. Avatar's assets under management and in overlay strategies for U.S. institutions total $5 billion.
Avatar's model is interest rate sensitive, seeking liquidity with reduced risk in the markets, said Francine Goldstein, managing director. Asset allocation determined by the three-way model was 50% cash and 25% each in stocks and bonds in July, a big move from the allocation of 50% stocks, 35% bonds and 15% cash in January. When interest rates rose in February, said Ms. Goldstein, the TAA model began to read negative indications and moved asset allocations by the end of March to 30% stocks, 25% bonds and 45% cash.
"The model is quantitative, but also partly qualitative, measuring investor liquidity in the markets. Our sentiment indicators are pointing out essential pessimism in this market environment. Yes, there may be some short rallies here and there, but the basic background is still pretty risky. Until there's some slowdown in the economy and interest rates drop, we're likely to remain in this somewhat defensive posture," said Ms. Goldstein.
One TAA manager's model has yet to move into a bullish position on bonds.
The quantitative model used by R.M. Leary Co. Inc., Denver, has been swinging TAA allocations widely this year, from a 100% domestic equity position in January to 100% cash in March. July allocations are 20% in cash, 60% in domestic equities and 20% in international equities. R.M. Leary invests in mutual funds using a TAA strategy for $50 million in U.S. institutional client assets.
A move into bonds is unlikely anytime soon, said Kate Leary Lee, the company's president.
"We use bonds as a defensive haven, and they're still much too dangerous, expensive and volatile, although they have been firming up a bit in the last few weeks. We don't want to end up losing money while in our safe harbor.'